Dividend Investing is very popular among retail investors, but it has certain risks. We discuss the 4 biggest risks of dividend investing, so you can learn how to minimize them.
Dividend investing is probably of the most appealing investment strategies. While it is very popular with retail investors, some fund managers are also attracted to the idea of investing for dividends. This is why many asset managers offer high dividend funds.
One the reasons why dividend investing is so attractive is because investors think that, since dividends are being paid out, the return they make is less exposed to market fluctuations and, therefore, there is little risk in it.
Nevertheless, dividend investing has its own idiosyncratic risks. Investors should learn about them in order to minimize the potential negative consequences of this investment strategy.
In the next few sections, we will analyze the 4 biggest risks of dividend investing, and how you can deal with them as an investor.
1) Excessively High Dividend Payout Ratios
The dividend payout ratio is the percentage of net profits that go towards dividend payments. In general, the higher the dividend payout ratio, the less opportunities the company has to invest that money productively and grow the business. For this reason, profits are being distributed to shareholders in the form of dividends.
There is nothing wrong paying large dividends to shareholders if we are talking about a mature company. The business can still be solid and profitable. However, a certain portion of the profits is always needed to modernize things. After all, machinery and computers need to be renewed on a regular basis just to keep operations running.
For this reason, if you see that a company has a dividend payout ratio higher than 80%, there is serious risk that the company may be losing capital or taking on too much debt. Dividends may be getting paid at the expense of renovating equipment or increasing financial leverage.
Therefore, make sure that a company’s profits are sustainable in the long run, and the dividend payout ratio is not excessively high. Failing to pay attention to that is likely to lead to an unexpected dividend cut in the future and a falling stock price.
Related to this point, whenever to you see companies with dividend yields higher than 10%, be careful. The market sees a lot of risk in those companies. Of course, the market may be wrong. But it is worth analyzing a company’s financials before investing in it.
2) Overexposure to risky sectors
Not all sectors are the same, and there are many reasons for that: different growth opportunities, capital requirements, commercial margins, debt levels, and so on. Although each company is unique, companies in the same sector usually have many things in common.
Given that not all sectors pay similar dividends, it is important to understand why that is the case. Sectors that pay high dividends tend to share certain characteristics. By investing for dividends, we may be concentrating our assets in certain sectors without us being aware of it.
If we invest exclusively in high dividend paying companies, we will be investing primarily in already mature companies, with low growth rates, higher debt levels, and in cyclical sectors. In other words, we may be too exposed to the economic cycle.
As a result, our portfolio may lack diversification and suffer heavy losses if there is an economic downturn.
3) Lower likelihood of high returns
By investing in high dividend sectors, we may be concentrating our investments in companies with fewer growth opportunities. This means not investing in sectors that have a lot of potential to grow, particularly technology companies.
If we look at the four sectors with the lowest dividend yields on the Pan-European Stoxx 600 index, we will find the following:
- Consumer Staples (defensive)
- Industrial (sensitive to the business cycle)
- Healthcare (defensive)
- Technological (sensitive to the business cycle)
As a result, if we prioritize dividends when we invest, we will not benefit from the future growth in sectors such as technology and healthcare. Similarly, we would also be neglecting many defensive sectors such as consumer staples.
The consequence of that is that our portfolio may suffer heavily in times of economic recession.
4) Taxes on Dividends
Finally, another negative aspect of dividend investing is that we may have to pay more taxes. If you use an investment account where you do not have to pay taxes, or live in a tax-free country such as Singapore, this aspect is less of an issue for you. Taxes erode the value of our assets.
Let us illustrate this issue with an example. If we have a stock portfolio worth $100,000 with a dividend yield of 5%, we can expect to receive $5,000 in dividends every year. So far so good.
However, when a company pays a dividend, its share price falls by an equivalent amount. This means that, if the market did not move at all, the value of our stocks would drop to $95,000.
The issue is that those $5,000 in dividends would be subject to taxes. Most countries charge a withholding tax to their companies paying a dividend, as well as income taxes to their tax residents receiving dividends.
If the combined tax rate on dividends, after accounting for both withholding and income taxes, is 30%, we will have to pay a tax bill of $1,500. The net result is that we will have $3,500 in cash and $95,000 in stocks. We will have experienced a loss of $1,500 due to taxation associated with dividends.
I want to conclude this post by encouraging you to invest in stocks that pay good dividends if that strategy suits you. Some of those companies have excellent businesses. However, do not focus exclusively on maximizing dividends as you may end up missing on some good investments and taking on more risk than you had anticipated.
Instead of prioritizing dividends, you could prioritize profits, growth and a solid financial position. Receiving income in the form of dividends is certainly nice, but you can generate income at any time by simply selling some stocks that have appreciated due to their good business performance.
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